Episode #221: Chris Davis, Davis Advisors, “As Human Beings, We Don’t Welcome Fear And Panic…As Investors, We Welcome The Bargain Prices That Those Emotions [Tend To] Produce”
Guest: Chris Davis joined Davis Advisors in 1989. He has more than 28 years experience in investment management and securities research. He is a portfolio manager for the Davis Large Cap Value Portfolios and a member of the research team for other portfolios.
Date Recorded: 4/29/2020 | Run-Time: 1:13:10
Summary: In today’s episode, we’re talking stocks and investor behavior. We begin with Chris’s background and transition into some of his early lessons about investing and compound returns. We hit on investor behavior and trying to keep investors behaving in their own best interests.
We discuss current markets, owning durable and resilient businesses, and the thinking behind the fundamental process at Davis. We even get into some thoughts about opportunities in markets today, from financials to energy.
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Links from the Episode:
- 0:40 – Intro
- 1:27 – Welcome to our guest Chris Davis
- 2:44 – Learning about value investing and benefits of compounding
- 11:12 – One Up On Wall Street (Lynch)
- 11:30 – Future of financial literacy in the US
- 12:08 – Security Analysis (Graham, Dodd)
- 13:30 – Moneyball: The Art of Winning an Unfair Game (Lewis)
- 13:31 – Ship of Gold in the Deep Blue Sea: The History and Discovery of the World’s Richest Shipwreck (Kinder)
- 13:40 – Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (Poundstone, Arthur)
- 15:38 – Titan: The Life of John D. Rockefeller, Sr. (Chernow)
- 17:47 – Chris’s first investment
- 20:51 – Chris’s windy path to investing as a career
- 24:26 – Promoting healthy investor behavior
- 29:40 – Fear and greed and reaction to Q1
- 36:49 – Financials in 2020
- 41:16 – The energy sector in 2020
- 50:47 – Futility of short-term predictions
- 58:36 – Chris’s global orientation
- 1:03:38 – Areas of interest in the future
- 1:09:05 – Most memorable investment
- 1:12:12 – Connect with Chris: Davis Advisors
Transcript of Episode 221:
Welcome Message: Welcome to “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome, podcast listeners. I’ve got a great show for you today. One of my favourite dudes on the planet, our guest, has over three decades in investment management and security research experience and after joining David Advisors in 1989. But that’s not it. His family’s been managing mutual funds continuously since the 1960s. In today’s episode we’re talking investor behaviour in stocks. We begin with some of our guest’s early lessons about investing, compound returns, and on the challenges of investors behaving in their own best interest. We discuss current markets, owning durable and resilient businesses, and thinking behind the fundamental process of Davis. We even get into some thoughts about opportunities in markets today from financials to energy. Please enjoy this episode with Davis Funds’ Chris Davis. Chris, welcome to the show.
Chris: Thank you so much. I’m glad to be here.
Meb: So I am here in Los Angeles. You’re where?
Chris: I’m up in the Hudson Valley right across from West Point, about 60 miles north of New York. So sort of surrounded by history, which is probably good at a time like this.
Meb: One of my favourite podcast episodes we did from when my wife was pregnant, we were in Hawaii and the entire episode, there were roosters in the background. So if we hear some goats and cows…well, you got any chickens up there? What are we gonna hear in the background?
Chris: You could hear some chickens or you could hear some grandchildren. I think the other thing that’s been great for perspective is I’m sheltering with four generations of my family. So I have my mom here but I also have my kids and my grandkids. And so it really also helps remind you of sort of the arc, and when we talk about long-term investment arcs, it’s sort of interesting to look at a span in this household that will really go from the 1930s and will probably go well into maybe 2100. And it’s an amazing thing to think about in terms of lifetimes.
Meb: Are you indoctrinating the young crowd there as some…the ways of the value investor? Are they already all smitten with the digital currency world? How does it work?
Chris: There’s like this iconic story in our family that is a true story about…there were a lot of kids over multiple generations but very few ended up in the investment business. But my father and grandfather were determined to make sure everybody was financially literate. And they had all different ways of teaching it, but one of the most powerful lessons was I had to work a summer with my grandfather. He was down on Pine Street, down near old Wall Street, and we were walking by a hotdog vendor and I asked him for a dollar to buy a hotdog, which is what it cost from the vendor. And he said, “Do you realize if you invested that dollar instead of spent it and you lived as long as I have and you earned the same returns that I’ve returned that that dollar would be worth a $1,000 when you’re my age?” And I said, “I hadn’t realized that.” He said, “Is a hotdog really worth a $1,000?” And by the way, he was right. I checked his compounding and that was like 960 or something. It was sort of amazing. But I liked the joke that in that one moment he taught three lessons and he taught the sort of…the unbelievable miracle of compounding. I mean, it is. You just can’t reinforce that enough with kids. You can do the penny a day doubled for a month and there are all different ways to do it, but for me, the $1,000 hotdog was one.
Then the second is like the value of a dollar, and in my lifetime the purchasing power of a dollar is down like 86%. Isn’t that amazing? With no vol, no risk, no vol, but somehow, you’ve lost 86% or 87%. And so there’s this sort of… And then the third is just about the indignity of being dependent on somebody else for your financial resources. I remember thinking I never wanted to ask for money again. And, of course, the big part of the investment business is recognizing that for clients, real risk is about dependent. There’s a lot of dignity in financial independence and a lot of indignity in becoming dependent. So anyway, a long way of saying, “Oh, yeah. We’re indoctrinating the lessons, and the $1,000 hotdog is right at the centre.”
Meb: I would actually like to stay on that thread for a minute because it’s an area I struggle a lot with. I have a young son but have also seven nieces and nephews. And for a country, we don’t teach personal finance in high school or college, really, even unless you elect into it. It’s certainly not even investing. I was giving a talk in Dublin last year, it was to Trinity College students, and tried to make a very similar analogy as your family did, where I said, “Look. Many of you are about to go on spring break, whatever the equivalent is into this semester. You’re probably gonna go to Ibiza. Maybe it would be Cancun or Caribbean in the U.S. I don’t know.” And I said that, let’s say, it’s gonna cost you $2,000 or euros. Maybe a 1,000. Whatever it is. Let’s say 2,000. It sounds better.
Or you could go backpacking and camping with your friends and not spend that money and put it in an investing account, and again 50 years from now you will have $200,000 or whatever the equivalent may be. Can you have empathy with your future self or can you look that far ahead? But then I said, “Now, the question becomes, is my advice to tell you not to go to Ibiza?” I was like, “No. You all should probably go because you’ll have a lifetime of memories and, who knows, maybe you’ll meet a spouse there. I don’t know. But every dollar you spend or save has that sort of massive potential.” It’s hard as a young person to think that way. It just…as we’re all 20 years old, it’s impossible to think of ourselves as an old person. So it’s that lesson of compounding. We spend a lot of time thinking about and I don’t know if I have any good ways of conveying it, but I may…the hotdog lesson may be a good one as well.
Chris: And by the way, with your students there, they will meet a better spouse backpacking in the highlands than they’ll meet in Ibiza. So actually there’s probably double reason to go back. You’re not saying short-change your experiences. You’re saying, “Don’t buy into the high spend lifestyle because it ends in ruin for most people.” Enough pull it off that you have these glamorous sort of ideals, but the sooner somebody can buy into the idea of just what you said, having empathy for your future self, the idea of deferred gratification. And by the way, if you really enjoy deferring gratification, you’re not really deferring it. You’re sort of getting a… Charlie Munger once said to me that he took so much pleasure in deferring gratification, he wasn’t sure he had really deferred any. It was such a sort of pleasure for him.
And so I was so furious at my daughter’s school in about seventh grade. It was a New York City school, independent school and they said…oh, she said, “Oh, I’m very excited. They’re doing an investing class spring semester.” And so I said, “Oh, this will be interesting. Show me your homework and your assignments.” And it was a girls’ school. They taught the girls how to read the stock tables, and then they told them what a PE ratio is, and then they showed them what stock tickers were. And then they all had to pick a stock and then they would track it each day on a piece of graph paper for a semester. And I was so furious at what sort of crazy propaganda are you confusing these kids with and trying to communicate that’s investing. So I made such a stink that, of course, they did, you know, the worst possible punishment for a loudmouth parent. They said, “So why don’t you come in and teach it?” And just like you at Trinity, I found myself confronted by a group of very intelligent, very opinionated seventh grade New York girls. But the way I did it, and I really do think that there’s use to this, is I said, “I wanna talk to you about companies and businesses. And what sorts of companies are there? Like name a company.” And they started naming companies they knew, and one said McDonald’s. I put that on the board. I said, “Okay, now if I said you own McDonald’s, what does that mean? What do you own?” And everything they said we put on…stores. I didn’t get into the franchise system so I just said, “Well, stores and the playgrounds.” And finally somebody said, “I guess you own the brand. Nobody else can call themselves McDonald’s.” So we put the brand and we put all this around and put a circle around all the things that they called out.
And I said, “Okay. So that’s the company. Now let’s say we all own it together. Does that mean that Susan owns the playgrounds and Debbie owns the brand and somebody else owns the Coca-Cola and the Happy Meal toys?” And they were like, “No. We have to share it.” I’m like, “Share. Yes. Share. You have a share.” So we divided the pie into the shares for the number of people in the class. And then we started talking about, well, what would you do to make your share more valuable? What would make the share bigger? And they talked about, “Well, the circle has to grow. The pie has to grow.” And so then, all of a sudden, they’re arguing, “Well, you could charge more.” But what if you charge more and fewer people come? Or you can put nicer toys in the Happy Meals. But then maybe you have to pay for the toy. And by the end of the class, they’re talking like good Wall Street analysts. They’re talking about long-term investors. They’re asking the right questions and they’re thinking about owning McDonald’s in those terms and they’re not talking about PEs. And this was the real gift of my dad and my grandpa. I watched my dad get off the train at night commuting out of the city, and you’d see 25, 30 grey faced men, and it was all men back then, getting off, dragging their briefcase, and my dad would come out with this like spring in his step because he just was so excited about that whole idea and he communicated it so viscerally that stocks are ownership interest in businesses, and businesses are people and ideas, and businesses grow and adapt, and they have cultures and personalities, and they make mistakes, and they can learn from them or sometimes their mistakes take them down.
And so we had this sort of view of investing that was so different than what I saw all these Wall Street bankers and things sort of hopping off the train. So I think I sort of was lucky to grow up that way and I feel like that sense of communicating that to kids, it’s something that is just missing. They say every profession is a conspiracy against the laity. And I think a lot of Wall Street…a lot of the investment profession likes to obfuscate. I think it sort of creates the jargon and the opacity. It makes it hard for people to understand. And Peter Lynch did an enormous service when he wrote that book “One Up On Wall Street” all those years ago, and it wasn’t a perfect book but it really…it was the most eloquent articulation I’ve ever seen of that very simple idea of what is investing, what are businesses, why do stocks go up over time, why do they go down. And you can get a lot of traction out of that mindset.
Meb: It’s a thing I struggle with, and I would actually love to hear your thoughts on if you were to try to sit down with that class and assuming you’re not gonna be teaching it but just to give them some resources…I mean, the Lynch book. We did a survey once where I said, “Hey, look. If you were to give a high school, college age student maybe that’s graduating with a business degree, just one investing book to teach them about investing, what would you give them?” We got something like 500 different books, you know. And then there was a few on there, while amazing books, are probably not great starter books. I mean, giving someone “Security Analysis” as a first book is probably…it’s gonna be tough.
And so that’s something that I struggle with for a long time and still do as far as… I think it’s a great business opportunity, by the way, for someone to do sort of this Rosetta Stone for investing curriculum. But I’ve got enough on my plate. I’m waiting for someone else to do it.
Chris: Maybe we do it together because we have a thing at our company, we call the internal CFA, because I got so upset that when you do the CFA now, there are things like the “Intelligent Investor” aren’t even on the reading list. And, by the way, going back to kids, a really great way to get your kids that sort of information is if you come up with that list of books, pay them 100 bucks for each book that they read and then write a summary about that book. And if the books are really valuable, that will be the best money you ever spent. I’ve actually done that when you have people who say, “Oh, my kid wants a summer job. They’re a high school senior or something.” We’ll often do that. We don’t tell them that it’s make work. What we say is, “Well, we have all these books we recommend to clients and we recommend, and it would be really useful on our internal website to have a summary of the books. And so we’d like…your summer job is to write those summaries for us for these 10 books.” Well, of course, we don’t need the summaries but it’s a great gift to those kids. And by the way, so those books, there’s no one. I think the danger is trying…because every kid is… But I would start with things like “Moneyball,” “Ship of Gold.” I don’t know if you ever read that book. “Ship of Gold” is breathtakingly…it’s the same story as “Moneyball,” by the way, which is the same story as “Fortune’s Formula.”
I don’t know if you ever read that. They’re all about people that brought a rigorous, disciplined, analytical framework to an industry that was really characterized by speculation, old wives’ tales, rules of thumb, but basically by hokum. And they brought this analytical rigor and discipline to this sort of speculative industry, and all three of them got wildly rich for doing so. So, of course, we all know the story of Billy Bean and “Moneyball” and bringing that sort of rigor versus what does a pitcher look like. Really just focusing on the data. “Ship of Gold” was about the activity of treasure hunting. And you think of that as, you know, old pirates, maps, and so on. And this young engineer that was just brilliant basically brought this rigor to the idea that while people look for shallow wrecks because they can get down and get the gold off, and he had the opposite. He thought, about what are the deepest wrecks? Can he use technology to find them? And then you don’t need people to go down there. You can send robots. And he built robots and he created by far the most valuable items and literally billions, I think, when all was said and done of gold that was brought up from this shipwreck, the South America out in the Atlantic. But it’s a great story, but it’s also a story about bringing that sort of analytical discipline and that outsider’s framework.
And then “Fortune’s Formula” was, of course, about the MIT group going and breaking counting cards and blackjack. And they’re all great stories that will appeal to different temperaments, but they all tell the same story, which is really that story of rigor in the face of something that everybody else thought was kind of luck and speculation and insider trading, insider information or know-how, but it really…you could have rigor and discipline. So I think those three are great investment books that aren’t investment books. I think “Titan,” the biography of John D. Rockefeller by Chernow, that’s a fabulous investment book. You only need to find one person like that in your career. It could be Jeff Bezos, it could be Jamie Diamond, it could be Bill Gates, it could be Warren Buffett, but the story of how one really driven person…and you didn’t have to find John D. Rockefeller when he was 25 or when he was 30. You could’ve found him when he was 60. You could’ve found him when he was 70 and you still made a fortune investing with him. And so just understanding the power that an individual can have in that mindset creating businesses, creating industries. So anyway, I love that topic. I think you should do that course. I’ll give you my whole reading list.
Meb: I think you should do it. We’ll collaborate on it. It’ll be a summertime quarantine project. But we’ve talked about this and I actually really like the idea of a curriculum because the way a lot of parents go about it, much like every single class, by the way, does it the way you talk about, which is the stock market investing game where you’ve gotta pick the winner for the next three months as if somehow the process relates somehow to the short-term performance. It teaches the wrong lessons, but the idea of building a curriculum and a foundation where it’s an entire…whatever it is. Some are three years’ worth of education is probably, I think, the right way to do it.
Anyway, I smiled a couple of times when you were talking because, one, there used to be a publicly traded shipwreck company. I think it still trades but it’s down microcap level that was trying to do the shipwreck as a business, as a public company. Ran into all sorts of regulatory issues. But I was also smiling when you said McDonald’s because when I was 12, we found this after my father passed away. He was an engineer by background but very involved in investing and business. I found an old postcard I had sent him from camp talking about…this is like the nerdiest possible postcard, but talking about investing in a few companies. It was like Anheuser-Busch, Disney, McDonald’s, and something else, and had I just been Peter Lynch and put my allowance in that, I probably wouldn’t even have to be in the investing world. I could just retire and be done with…sit on those dividends.
You came from an investing family but do you remember your first investment ever or was there a definitive time? Because I know you took a little bit of a whiney path to come back to the investing world. Was it when you were young or was it later in your career?
Chris: We were young. My father had a great system where he said, “If you did work on a stock…” And what he meant is you had to read the annual report, you had to write one page about it, and you had to call the company. And if you did that, that he would match whatever you put into that stock and he would guarantee you that you wouldn’t lose money. And so that was a hell of an enticement. And, well, this is sort of interesting because…by the way, it’s so boring that I think it’s interesting, which is that the first company I bought, believe it or not, was an insurance company called Associated Madison. The ticker was A-M-A-D, AMAD. And one of the reasons was I remembered my father talking about this very, very aggressive, brilliant manager. When I was a kid, he would’ve been in the 60s. In fact, he briefly, I believe, ran the Magellan Fund, believe it or not, before Peter Lynch but after Ned Johnson. And his name was Gerry Tsai. And then he went and created his own investment operation and then he took control of this insurance company.
And I just remember my dad talking about this exciting investor and the idea that he owned an insurance company I thought was so sort of intriguing. Then I had no idea what insurance was. But it was just to me, I thought, “Wow. It sounds like such an atypical move.” And so the stock was trading I think at like 16 and I bought it in. It was sort of a steady building machine. It was nothing great but it sort of gradually went up, and I would track it over time, and that I went on and bought some others, but I just remember that one in particular and I remember it entirely being driven because I had heard about this great manager who was a great investor, very aggressive and young and sort of an upstart. And the idea of somebody like that in the insurance industry really sort of somehow resonated with me because I thought of insurance as so boring so I thought, “Oh, this will be like a fox in the hen house.” And it did fine but it was not a retire rich stock, but that was probably the first stock that I ever owned.
Meb: And I almost wish it’d be a scenario where I could go back and say that it was an issue like the coffee can where you just weren’t allowed to sell them because I would love to see a record of all the companies I invested in. I mean, mine… So I graduated high school in the ’90s and so I was certainly…had the bull market blinders on, and I think…I can’t remember if it was Etrade was my first stock but I do remember…on kinda my own, but I do remember certainly investing in Lucent, which was funny because in college we took a security analysis class a couple of years later, and one of the case studies was find all the red flags for short selling on why Lucent was a great short, which was funny as well.
Okay, so you grew up in an investing family, you took some time on a potentially different path, went to school in Europe. A potential almost seminary start but then kinda came full circle back to investing. What was sort of the final reason why you got interested in sort of finance and investing as a career as the past started to diverge across or whatever may have been the case in your 20s, I imagine, at this point?
Chris: I had a big advantage of knowing and admiring two people that loved what they did. And so it always seemed sort of interesting to me, investing. And I think it’s funny you mentioned the side-track and seminary. I did a graduate degree in theology and I think that I wasn’t really…although I had intellectual interest in investing and I could see how it made these two people I admired happy and fulfilled and, of course, wealthy. I used to say all the time, “It’s a low calling.” And it was actually a friend of mine who is a close friend who I really admire, who has been incredibly successful in the world of business and is actually a CEO now, but I won’t mention who it is because I don’t think it’s my story to tell. But we were sitting near each other and when he had met, we met actually in Omaha, at a Berkshire meeting, and he said, “Stewardship is actually a very high calling and it’s a very noble profession. And if instead of saying you’re in the investment business, you remind yourself that you’re in the stewardship profession, that may sort of change your mindset.”
And he was absolutely right. So that was in a sense when I could finally allow myself to indulge this deep interest and curiosity and passion about companies but do so in a way that I actually felt good about myself. Remember, you were in the ’90s and the [inaudible 00:22:39] this for me was the ’80s so it was the yuppies and Gordon Gecko and greed is good. So I didn’t feel great about the idea of going to Wall Street. And so it was that mindset change when he talked about a stewardship profession versus the investment business. And we really have tried to make that sort of the cornerstone of our firm and how we think about what we do. One of the things about…I was very lucky to come from a wealthy family and successful.
But one of the questions we sometimes get asked is you have all this insider money in your funds. You really…in many ways, we run our firm like a family office where we’re really thinking about investing our own family assets and…why do you bother with clients and managing mutual funds? And we feel like that goes back to that idea of stewardship that what we do has life-changing consequences for our clients. When you run a mutual fund, your average client might have $28,000 with you. It is life-changing if you can do a good job with that over a long period of time. And that’s one of the reasons we do spend a lot of time on investor education and sort of investor behaviour, as well as trying to help people understand what they own and why they own a tough conviction to get through times like this. Because, in a way, it’s not just your investment returns. It’s whether you’ve comported yourself in a way that you get clients who are willing to come in in bad times or stay with you in bad times versus the more common tendency, which is people come in after good performance, they get out after bad performance, and they get what Jack Bogle used to call the timing and selection penalty. And so a big part of our culture is how do we not just generate good investment returns, but how do we reduce the timing and selection penalty by really building a relationship and deep conviction with our clients.
Meb: And how do you try to do that? I mean, for both of us who are on public funds and we live in a world where an investor can just log on. They don’t even have to call anyone anymore. They can just log on. They don’t even have to log on. They can just turn on their phone, click a button, sell your fund. In Q1 of 2020, I think, for many was pretty painful. We’ve both been through a few bears. So we have the scars to talk about it. But is it simply through education? Is it through trying to communicate? What are some of the best practices on keeping people behaving in their best interests? Is it trying to have a financial advisor? What are your general thoughts?
Chris: It is a great question, and, of course, the answer is probably the same answer you have to give your kids about a lot of things, which is there are no shortcuts. And we all had a wonderful teacher in Warren about you get the shareholders you deserve. So it takes a long time. And I think it is about honest communication in the good times. And I will say we have built our firm with advisors and in partnership with advisors, and I had a lot of arguments with Jack Bogle who I admired greatly and I would be proud to consider him a friend. We certainly worked on projects together, and he was somebody I just found him delightful company, and we worked on a real wonderful project together before stock options were required to be expense, trying to make that happen. And the way we felt we could make it happen is we didn’t need the accountants to change the rules. We needed the shareholders to simply vote on it. And so Jack and I thought…and along, by the way, with Bill Miller. The three of us worked together on this project. We thought, “Well, maybe if we can convince the largest index funds to insist that stock options be expensed, then the companies will have to expense them.” And so we felt we could do it in a sense through the proxy voting process rather than wait for the accounting profession to catch up to that sort of reality.
And so, anyway, I’m on a massive side-track. We can come back to that, but what I’d say is one of the things that Jack and I used to talk about a lot is I used to say that I felt that his focus and obsession on costs undermined or was negated by the fact that investing is a profession. And he’d say, “Well, what do you mean?” And I said, “Look. You’ve got a new heart. When you went for your heart surgery, did you hit the cheapest doctor?” In a profession, costs have something to do with professional duty and fiduciary duty, but it’s not the same thing. And so our view very early was that managing a client and managing behaviour is different than managing a portfolio. And we felt that the best advisors add huge value. And they have their clients, they have their clients’ kids, they have their clients’ grandkids, they’ve been in the business for 30 or 40 years. Now there are a lot of people in that profession that are not behaving like professionals, but we felt that the best of them really had that sort of deep alignment. So very early we decided we were gonna build our firm in partnership with advisors because in a sense the end client return was the product of two different returns. There was the return that the underlying investments generated and then there was the investor behaviour component, and that’s what we called the timing and selection penalty. Because usually that is a negative, like 0.8 or 0.7 times the investment returned for when people get in, when they get out.
So we used to say, “This is not a matter…” And I said this to Jack, “It’s not a matter of 30 basis points or 40 basis points.” That timing and selection penalty might be 250 or 300 basis points per year. And you can get that data, rough approximations of it by looking at dollar-weighted versus time-weighted returns and things like that. And so I used to say that I feel like you really undervalued the role of the advisor. And ,of course, if you look at the last 10 or 15 years, Vanguard has galloped into the advisor business and has really recognized that value of advice, and I think they do a wonderful job with it. But that has always been our focus, has been that advisors…if you look at what you pay, if you have a good advisor and you have a tendency towards bad investor behaviour, your advisor is probably underpaid.
Meb: It’s a very accurate statement. I mean, Vanguard now, like you mentioned, puts out that article where they try to quantify all the, of course, benefits of the Vanguard approach, but one of the biggest being the behavioural benefit of using an advisor from keeping you on track. And the analogy we often tell people is like, “Look. It’s not gonna matter…” I mean, yes, it does matter if you get 8% or 9% but more importantly, not is it eight or nine. Is it eight or nine or zero? And we have talked to, I’m sure you have as well, countless investors that probably sold after the financial crisis and never invested in stocks again just because it was too painful. And that’s a tough outcome and it’s honestly painful to hear. You guys had a quote on the website where it says, “If the brain is the most important organ for successful investing, the stomach may well be the second, as reason and judgment can easily be distorted by fear and other emotions.” That’s probably a good lead into Q1. Talk maybe a little bit about fear and greed and envy and everything else wrapped in with the stomach and particularly with Q1 and how you guys think about the world in the beginning of this new decade.
Chris: I wanna put a big caveat in front of wherever we go with the conversation from here, which is to say when you are going through a period of time where individuals are suffering and are afraid to start talking about the investment opportunities can sound really mercenary. And so I wanna sort of separate out two threads. And the first thread is to say, “Look. As human beings, we don’t welcome fear and panic. As investors, we welcome the bargain prices that those emotions produce.” And so what we know is that this has not been the first, it will not be the last time of fear and panic that we go through. And we started our funds 55 years ago or something like that. So we’ve gone through some pretty amazing and terrifying events. Think the hostage crisis and oil embargos and Y2K and stagflation and, of course, 9/11 and the financial crisis and the euro crisis and the Great Recession. There’s been a lot in there.
And if you take that all the way back to when my grandfather started and you start writing these things on a paper, COVID is gonna be one of those things. It’s not gonna be the biggest thing, it’s not gonna be the worst thing. It’s gonna be one of those things on that long arc. And my grandfather kept this graph from the day he started in the business and every year he would mark it. It would go along. It was this long, long graph. When I was a kid, it seemed to go on forever of what was the market return over that period. And you could write all of these things on that graph, but the more you zoom out, the more you realize the resiliency, the adaptability both of human beings as individuals… I mean, you look at how people…their resourcefulness, the way people have adapted to this lockdown, the incredible ingenuity that’s coming out of new treatment and vaccines accelerating, there is enormous adaptability in our species and, of course, of our businesses. And so what I’d say is when we buy a business, any business we buy, we assume we are gonna own it in a recession. We assume there will be dislocations. We assume there will be times when the dollar is collapsing and the dollar is strengthening, times of higher interest rates, lower interest rates. What we know is those things are unpredictable. They come at random times. Nobody predicted Y2K, the housing collapse, the oil embargo, the hostage crisis. These things were not predictable. What is predictable is that unexpected dislocations will happen.
So when you invest, you better assume that it could start the day after you buy whatever company it is. So question one when you buy a business is, is it durable? Is it adaptable? Is it resilient? Does it have the balance sheet? Does it have the earning strength to get through a time like that? And so when we came into this environment, we thought, “Our portfolio is wonderfully positioned.” We have 9 of our top 10 companies have net cash or have reduced leverage in the last 5 years. I mean, we have business models. A lot of our companies are in their second century because of our focus on financials.
Now, the stocks might act like crap. The stock prices might go down a lot, but the businesses are gonna get through it. So we had that sort of resiliency in the portfolio. So once this environment started, obviously, we have a global research team so, of course, we had been following what happened in China. We have big investments in Alibaba and DD and TenCent, a few Chinese companies. So we had been tracking. In fact, I’d been in China with my partner in August and September, visited a whole bunch of companies. So we sort of had that orientation going in. But as this began to unfold, our view was, “Okay. Let’s basically put all companies into three categories.” Category one is you better avoid them, or if you own them, you probably should sell them. It’s companies that have high fixed cost, plummeting revenue and levered balance sheets. Now because we look through the lens of owning companies through thick and thin, having companies we own for 10, 20, sometimes 30 years, we never intentionally have any companies that have those characteristics.
Now every once and a while the tide goes out and you find one of your companies flopping in the mud naked. So that can happen, but you think particularly in this environment some energy companies, for example. But by and large, companies that have that combination are not resilient. They can do great, but you can be very vulnerable. And then you’ve got a second group of companies, which are the companies that have somehow benefited from this environment. Not in a malicious or malevolent or opportunistic way but just because of their business model. Think of gaming and home delivery, the Amazons, the Googles, the Facebooks, and so on. And we see that on a global platform. Disney, of course, all the Disney Plus subscribers and so on. And with those companies what’s amazing is, I think, in some cases the markets have assigned them even more value for an effect that is unlikely to be a permanent effect. So we look at that and we say, “Well, we better…some of these might be a little bit an opportunity to trim them. Some, the intrinsic value really may have gone up.” I mean, a lot of parents who got Disney Plus are never going back.
And then the third lens is the one that’s the most exciting in this environment. And these are the companies where the stocks have gotten killed because nobody knows what they’re gonna earn in the next month, the next two months, the next quarter, the next two quarters, even this year. But there’s enormous confidence in their resilience. They will be able to get through this period. Unlike category one companies that are gonna have to finance and you don’t know what the terms of that financing will be. In the financial crisis, banks that were in the TARP program had to give up 20% or 25% of their equity. AIG gave up 90 or 95 and Fannie May gave up 100. So if you’re forced to be bailed out, you don’t know what the terms are. It may work out, it might not. We’re not in that game. But this third category of companies are companies where you know there’s that resiliency. Think of United Technologies, think of Berkshire Hathaway, think of the banks. I mean, they could not be in a better position for this crisis versus the last one. They’re just sort of leaning in. So that’s sort of, as we’ve come into this period, that’s been our mindset. And so we’ve called this sort of a high conviction downturn because we’ve had a lot of conviction in how the companies are positioned. And the financial crisis was not like that. The financial crisis, the entire system could’ve shut down. Wells Fargo could’ve been nationalized. I mean, lots of things were happening that were, I’ll say as an investor particularly in that sector, completely disorienting.
9/11 had less economic impact but it was psychologically terrifying in a way that the financial crisis was not terrifying for the average person on the street. But we were New Yorkers so that was very deeply jarring. This has been a much more high conviction period. We feel the portfolio was sort of prepared. So we’ve had a lot more equanimity and sort of been able to maintain that sort of perspective through this period.
Meb: I know you guys have a particular interest and focus on financials. Is that a sector you think that broadly is attractive? Is there quite a bit of dispersion between the industries within financials? Any general thoughts on a world in which they certainly didn’t teach this in the textbooks when I was coming up? You have a situation where a fair amount of the world has negative yielding sovereign bonds. How do you think about the financials in 2020?
Chris: Financials is a dangerous sector to throw a dart at. You do have a lot of dispersion, a lot of different models, a lot of different cultures. With that as a caveat, I would say that within the financial sectors are probably the biggest opportunities we see in this environment. And this is, of course, because they went through the financial crisis. And because they went through the financial crisis, there are things like the stress test that these companies have to pass every year. Now, the stress test in the what’s called the severally adverse scenario of the stress test means this. The regulators come into your bank and they say, “We wanna make sure that you are well enough capitalized that you could withstand a downturn that would be worse than the great financial crisis. But we’re gonna model a 3-year downturn with GDP down 8%, unemployment at 10%, the S&P down 50%, commercial real-estate down 35%, single family real-estate down 25%. How are you doing then, banks?”
And so they have to pass that test every year without going below their capital thresholds. So if there is one sector in the entire S&P 500 that has been drilled and prepared for the environment that we’re in, it’s the banks. They have twice the capital, 90% more capital than they had before the financial crisis. They have way better liquidity, way better credit quality. They are leaning into this, and yet that’s the sector that went down the most. That’s the sector that… Capital One Bank, I wanna say, was down 55% or 60% at one point. Wells Fargo, which was already cheap, was down 45%. They were already cheap. They went down more, even though, they were, we would argue, way better prepared. So that’s where we’ve been finding the real opportunities. I mean, people say, “Boy, it’s hard to believe the market has come back so much so fast.” What we would say is, “Well, there’s still a lot of companies out there that are pricing a way worse scenario.”
And so looking, taking apart the market, it’s the financials in general. Within the financials, it’s the banks. Within the banks, our favourites are Capital One, Wells Fargo. Those two are the…really went down the most and seem the cheapest for different reasons, but U.S. Bancorp, we have a big holding in JPMorgan. I mean, I just think those things are trading as if it’s 2007 and they’re about to get diluted in the financial crisis when, in fact, under that scenario, that awful scenario I described, Wells Fargo would net generate capital. Net generate capital. So we’re gonna go through this period. I think investors are gonna come to see that resiliency and say, “My God. We sold the stocks in a panic because we remember the financial crisis but, in fact, they were resilient and well prepared.” And just to give you one historical perspective, I was talking to my father about this just last week and he was reminding me. He said, “In the 1950s high grade, good, conservative, boring banks traded at 15 times earnings because that’s how long it took investors to finally forget about the crash and the Depression.”
And what they realized by the ’50s is…they’ve gone through World War II, by the way. They’ve gone through subsequent downturns, but what people realized is, “Oh, my God. They really were made safe and sound after the crash and after the Depression. The new regulations, the banking regulations, the FDIC funds, the oversight has made them dull, boring, safe providers of growing dividends.” And I think we might look back three years from now and that’s where we could see banks really finally being viewed as dull, boring. Like utilities. The difference is utilities traded 20 times earnings and banks are trading at 7. And so that is a huge difference. Utilities have high pay-out ratios. Banks were paying out 30% or 35% of their earnings and generating these 4% or 5%, 6% dividends. So we think that just looks terrific.
Meb: You touched on a couple of interesting points there. One being how sectors over time can certainly go in and out of favour with investors of hot and not. I mean, I remember reading an old Schiller piece on sectors where he looked at long-term PE ratios on sectors going back to like the 1900s and even boring utilities hit a 10-year PE ratio of something like 60. And it was either the run-up of the roaring ’20s or aftermath. I can’t recall. But people think of utilities as somewhat of a super low PE, boring, but you’ve had this scenario over the past number of years where it could be… I don’t know what the flows have come from, whether it’s low vol, indices, whether it’s min variance, whatever, where utilities, you mentioned, traded at this kind of odd high PE ratio for kinda what they do. But another sector that kinda is a great recent example that used to be at…I think it was near 20% of the stock market and now is at like 2% is energy. And do you guys have any thoughts or perspective on what in the world’s going on in the energy patch?
Chris: You’re so right about how perceptions can change. And before I touch on energy, just to pick up on your comments about the low vol darlings. We think there’s a lot of risk. There’s…risk usually is worse where people feel safest. And if you go back to the financial crisis, you were safe hiding in dull consumer names, hiding in utilities, hiding in real-estate, pharma, things like that. But if you look at the S&P low vol index, the median PE got up to like 22 times, and if you look over the last 5 years, net debt increased something like 45% or 50%. And so increasing debt, higher valuation and the five-year growth rate and revenue was like 3% or something. I mean, these companies are burning the furniture to pay the dividends and yet everybody feels safe in them and they feel that they’re taking this tremendous risk in banks because that’s what hurt them last time. Well, isn’t that usually the way it is, right? People look at where they were safe the last time. They run to that but that’s become unsafe and the stuff that was unsafe last time has become safe specifically because of the lessons learned in the last downturn.
So I think that low vol index has a lot of risk in it and a lot more than people realize. People feel, “Oh, you’re safe? Oh, that company’s paid a dividend for 40 years, 50 years. It’s safe.” Well, look at the pay-out ratio and don’t look at the pay-out ratio just relative to pre-cashflow. Adjust it for the cash acquisition that companies have made and then look at the debt and you’ll see a lot of companies have been borrowing to pay their dividends. And I think that’s not a sustainable model. So Anheuser-Busch, Craft. People say, “Oh, but they had so much more debt than others.” But they may be canaries in the coal mine. I mean, a lot of things have changed. So I’d be a little careful with some of that low vol stuff where people feel very safe.
Now, energy. Well, energy is a great example where you just can’t stress test an energy company enough. Look, oil is a little like tobacco. As the society, what we said is, “Look. Tobacco is bad for us.” And because it’s bad for us, we’re gonna create policies and we’re gonna educate people and we’re gonna create tax structures that reduce tobacco demands. And so tobacco consumption falls every year but it’s also addictive and a lot of people are addicted. So that falloff takes a long, long time. I mean, if you had told me when I started investing and Phillip Morris sold a pack of cigarettes for a dollar that you could charge 15 bucks for a pack of cigarettes and people would still be buying them, you’d say that’s crazy. But, of course, it takes a long time when people are addicted. Well, the world is addicted to oil, and just like tobacco we say, “It’s bad for us as a society. There are high costs, there are long term costs. We have to create policies that reduce oil consumption over time.” So we’ll do it through tax and regulation. And by the way, rightly so. We’ll create alternatives and so on. But I think what the people who are real bears on oil forget is that that will take a long time. There will be a long, gradual decline and, boy, did you make a fortune in tobacco stocks over the last 25 or 30 years just because that curve takes a long time.
So knowing that oil will, at some point, trade between $50 and $80 a share because that’s really the price needed to satisfy demand for oil. And so demand may not grow. It may gradually shrink as alternatives grow. But in order just to satisfy the visible demand in year two, year three, year four, it’ll have to get there because that’s the price of producing that incremental barrel. So then the question is, “Okay. Well, I know oil is gonna get between 50 and 80 at some point in the future. Can I own companies that have the staying power to get there if oil trades way below that price for some period of time?” Now a year ago, if you and I said, “If oil trades way below that price…” We might’ve said, “Well, what if it trades at $30 for a year or two?” That would’ve seemed like an extreme scenario. Nobody would’ve said, “What if it goes negative? What if it trades at 10? What if Russia and Saudi Arabia get in this crazy pissing match and you get this sort of incredible effect?”
So there are companies that have huge value when oil gets back, and I think you can have high conviction that it will get back to much higher prices at some point in the future. The question is whether they’ll be able to get there. And if they’re able to get there, what the share count will be because a lot of them…if oil stays where it is for another year, they won’t make it or they certainly won’t make it without significant financing. And so now you’re in a sort of a timing bet and it’s a little bit like a lesson my father really rubbed in early on us was never to own stock options. And we’d say, “Why? Why don’t you buy an option? If you think a company is undervalued, options give you all this leverage.” And he said, “Well, options expire and it’s hard enough to be right. But if you have to be right about what’s gonna happen and be right about the timing, that is really increasing your risk.” And so I think that’s sort of where it is with energy. We have a very small waiting, 1.5% in companies focused in the Permian basin that are low cost producers, that have glorious reserves, good management, and have relatively good balance sheets. But we have not bought more because we said, “We think the most likely outcome is that they are really undervalued. On the other hand, we have to size them appropriately knowing that there’s a possibility that they won’t get through this period.”
So if you said, “You can buy a 5-year contract and make money with oil going from 12 to 50,” I would do it all day long because I think that’s almost certain to happen. But how to play that conviction is very difficult because there are a lot of companies where if oil stays at 12 for another 12 months or 18 months, won’t get through to the other side and, of course, in the futures market, you can’t buy that spread because futures are much higher. So it is a real conundrum, but I think tobacco is not a bad analogy for investors to have in mind about the long-term. Not the short-term but about the long-term that I think the people that hate oil are gonna be surprised at how gradual the decrease in demand is and I think the people that love oil are forgetting that people are innovative. The cost of solar has come down and there is gonna be a change in global consumption. It’s gonna take time but you can’t look at the last 20 years and expect that to repeat.
Meb: Interesting thing about the tobacco…I mean, if you read the Dimson, Marsh, Mike Staunton “Triumph of the Optimist” book…I mean, tobacco was arguably…I think it was the best performing industry of all time. And I smiled as you said that because I went to a high school that was literally named after one of the large tobacco companies, R.J. Reynolds, in North Carolina, which was probably the last place on the planet that banned smoking at the school and restaurants and in bars. And you oddly enough don’t see any tobacco-themed DTFs, which is interesting aside.
Anyway, there was a great quote that I had tweeted out during sort of the oil stuff was from Lord John Brown who’s former CEO of BP where it said…this is from the book, “Future Babble,” but he was asked about the price. He said, “I can forecast [inaudible 00:50:00] it will vary. After that, I can gossip with you, but that’s all it is because there are too many factors which go into the dynamics of the pricing of oil.” And this is literally the CEO of an oil company.
But it’s funny. And as investors, everyone wants the certainty and prediction of what the future holds, but even this last year has been a great example. I mean, I said, “If you were to time machine back and go back and list a number of the economic outcomes of the past year, whether it’s unemployment, PMI, gold, volatility, anything, and then say, by the way, stocks are up over the past 12 months, would you believe me?” And I think no one would. And that’s the way the market works. It consistently confounds people.
Chris: Wouldn’t you think that forecasters would get a little humility in this? I mean, the futility of short-term predictions is just… We documented every different way in our literature. We show the average forecast of the top strategist for the S&P return in the next 12 months. The FED forecasts for a GDP change in the next 12 months. The top forecasters in, I think, the journal, twice a year, puts the interest rate projections. And we score them as correct if they get the direction right, higher or lower in a year from now. And yet, they’re wrong 60%, 70% of the time. And so you would think in an environment like this, people would say, “Well, I guess there is a lot of inherent unpredictability about short-term outcomes.” And yet, you see the opposite. Everybody’s an amateur epidemiologist. It is unbelievable to me the absolute conviction people have about what morbidity rates are or what the timeline to a vaccine is or when will the economy reopen. People have enormous conviction. It’s gonna be this or it’s gonna be that.
And by the way, even what is GDP gonna be this year? I’m looking at forecasts by people that are paid well that are different by a factor of three. Three times. Not 3%. Three times. And yet, everybody’s out there making these forecasts. And all I would say is the great opportunity in this environment has been to say, “Okay. Let’s look at some negative cases there.” Let’s say instead of three months, it’s five months. Instead of five months, it’s six months. Let’s get out 12 to 18 months. Now 12 to 18 months from now there is a broad acceptance of the fact there will be a vaccine, there’ll be better testing, there’ll be better treatment. This will be something of the past and we will be better prepared for whatever comes next, which will be worse.
And sports will be reopened and people will be going to the movies and so on. You know, maybe it’s 18 months, maybe it’s 24, but it reminds me after 9/11, people said, “Nobody will ever live in New York again. We are a terrorist target. Why would you ever work in New York City?” People get on with their lives. And so if you focus on that orientation, then you start looking for businesses where you say, “Well, I’ve gotta do is make sure I own a business that can get out that far.” If I have high conviction, they get out that far, then I don’t have to worry about the timing. But you just…I listen to these forecasts about everything about this disease path, virus path, about with the market, about GDP, about losses in consumer, loan portfolios, and they just are people who are getting paid to give a prediction because people wanna know, not because the people giving the forecast have any idea. And you think you would get some humility for just the reasons you said. Everybody I speak to now says how obvious it is that the market is gonna double dip, that it’s come too far too fast. And I would say, “Maybe, but what on Earth makes you think that you have the ability to forecast that?” Anyway, it’s an old saw at our place, but we get…one of my favourite quotes of John Kenneth Galbraith is just simply that the real primary function of economic forecasting is to make astrology look respectable. And I think there is a deep truth in that.
Meb: If there’s any academics listening that needs something to do for a summer thesis, we used to always say, “I would love to run an online project where you give investors tomorrow’s newspaper today.” Meaning like look, we’ll go back for the last 100 years, give you the newspaper front page and…obviously, it can’t be like the stock market’s gonna crash tomorrow but whatever. World War Two starts, Pearl Harbour, whatever. And then can you correctly forecast and come up with whatever the academics think the best way to do this one month, one year out, one week. And my guess is most people would be no better than a coin flip. Even if you had the future news flow. I mean, this past year’s an amazing example. I think most people would’ve assumed stocks would be down 50% with some of the news…
Chris: But if you go the opposite direction and you say, “Okay. We can’t know that.” Then people throw up their arms and say, “Why bother?” And you say, “Well, let me ask you a different question. Do you think Pratt and Whitney, ODIS, [inaudible 00:55:00], and Carrier, HBAC will be relevant businesses five years from now?” And everybody would say, “Of course.” Do you think they’ll be bigger? I mean, they’ve grown in every rolling five-year period since they were started. They didn’t know on average be bigger over the next 5 years, the next 10 years, Yeah. I mean, more elevators go in. They make a lot of service contracts, jet engines have predictable reprice cycles, and defence spending probably doesn’t go that…you look through that and you say, “Okay, well, if I can buy that business today at a 13% IRR, I don’t need to predict what’s gonna happen in the economy next week or what’s gonna happen from those newspaper headlines.” Here is something we can predict and we can’t…I say we can.
You can predict it with certainty. You deal with probabilities and then you build a portfolio where all of those probabilities are at work and you’re gonna get some wrong and some are gonna be better than you thought but in aggregate that is a compounding machine. And that’s why I think whenever we say, “The futility of forecasting,” what we mean is the futility of forecasting things that are unforecastable, whereas we would say, “There is an enormous ability to forecast whether or not the businesses that make up United Technologies will be more valuable 5 years or 10 years from now than they are today, or whether Wells Fargo will earn more per share over on average 5 years, 8 years from now than they are now.” And I think the answer is in every case we can’t say it’s certain but we could say it’s highly probable. You build a portfolio of those and that’s how you build sort of generational compounding well.
Meb: And for some reason I feel like people understand this more when you frame it as businesses. I mean, even their own house, I mean people can kinda get it when it comes to real estate. And I’ve sort of changed my mind on it over the years. I think it’s more of a feature than a bug but the illiquidity of private businesses as a potential positive because people can’t sell them and think in terms more of long-term. But, again, speaking as a public fund manager.
Chris: We have a huge advantage as public fund managers and we often sort of piss away that advantage. It’s that idea, the Mr. Market analogy, but if somebody owned an apartment building that they paid $10 million for and it generated a million dollars of rental income every year and it was well located and you maintained it, and somebody came by and said, “I’ll give you five million for it.” You wouldn’t pull out your hair and say, “Oh, my God. I’ve just lost half my net worth.” You’d say, “That’s still earning a million dollars a year. I’m not selling it for five.” And if the earnings went down to 800,000 and then they went up to a million two but they sorta averaged around the…you wouldn’t sorta be pulling your hair out thinking that the value is being crushed or spiking. And yet, we, as public managers, we have clients especially that look through that changing price as, “Oh, my God. What’s going wrong? What’s happened?” And I think real estate is a really helpful analogy, especially that sort of commercial real estate, because people understand that. And they understand that there might be times when you couldn’t sell that building for what you paid for it, but it doesn’t mean that the value of it has collapsed.
And so I think you’re absolutely right. It’s a useful analogy, and private businesses, people don’t really…they look at the earnings over time, the cash it produces, and they don’t have this unsettling whisper in their ear about what I’ll buy it from, what I’ll pay for it today, what I’ll pay for it tomorrow, what I’ll pay for the next day. So our liquidity should be an advantage and very often it becomes a disadvantage because people confuse price and value.
Meb: I’m gonna try to wind this down. Otherwise, I’ll keep you for the rest of the day. Haven’t even gotten to any of the questions I wrote down. I think a lot of investors, particularly in the U.S., tend to constrain their universe to the geography of our orders. You guys tend to have a pretty wide net as far as international investing. Any general thoughts on the way the rest of the world looks today in 2020 as you look out to the horizon?
Chris: Well, I think if you’re an investor starting companies and trying to value businesses, if you don’t have a global orientation, to use one of Charlie Munger’s more colourful phrases, you’re like a one-legged man in an ass kicking contest. And the reason is when the Berlin Wall came down and the world globalized, your competitor…if you had a manufacturing company in Ohio, your competitor might be in Hamburg or in Birmingham or in Rio or in Shanghai. And if you really wanted to be expert in valuing businesses, you needed to understand that global landscape. And that has happened globally in the same way it happened in the U.S. When I was started in the business, there were still these regional research boutiques that specialized on midwestern companies or New England companies or the companies of the southeast or California companies.
And you can remember them. They were some good firms. Addams, Harkness, and Hill, and Davenport. But their research…I remember at Addams, Harkness, and Hill was on Reebok because that was a New England-based sneaker company, but they didn’t report on Nike or it was on Shawmut Bank, but they didn’t report on Nation’s Bank or…of course it was called NCMB back then, but they reported on [inaudible 01:00:19] but not on Walmart because those were New England. And the same is true, when you really invest now in this world, it’s a global world. You have to look at each industry globally. And of course there are lengths and there are also inefficiencies that get crated. So the theme we talked about in financials in this environment, that’s a global theme. I mean, we’re large shareholders of the largest bank in Norway, the largest bank in Singapore. I mean, those are wonderful, well-run economies, conservative banks with huge excess capital and massive dividend yields. Now they’ve suspended them in this period because of some regulatory pressure, but those are gonna be big yield stocks a year, two years, three years from now. They are durable businesses, Switzerland, Norway, Denmark, Singapore. So that’s a global theme.
Then we can look like in China as a sort of a lens into the future of how our disease management unfolds here as we look at how the virus unfolds, as we look at how the economy unlocks. There’s a lot of analogies. All of the Chinese online consumer sector used to be imitators of the U.S. And, of course, that’s like the way the Japanese electronics industry used to be an imitator of the U.S. and then they became an innovator. Sony started as an imitator of RCA and they became an innovator and made better products. So Alibaba invented the advertising model that Amazon now uses with great success. So I think studying what’s happening around the world, you really do see opportunities and valuation gulfs, the Saffron, the large French jet engine manufacturer is a 50-50 joint venture partner with GE’s jet engine business. And yet every once and a while it will trade at a wildly different valuation.
So I think there are great opportunities around the world and I like that financial theme. I love the online consumer business around the world. The online technology leaders in China, I think, are very, very good businesses. And so we’re gonna watch this pandemic spread. The damage it will do in emerging markets may end up being greater than it is here although it can.. It’s a virus that tends not to affect the young as much and in many of those economies the population is much, much younger. Obviously, Italy had a very old population compared to Brazil. So I don’t think the course of the coronavirus is gonna really be the story of the global economy over the next 10 years. It will be over the next year.
So the opportunity to buy really high-quality companies when they’re trading at distressed prices with conviction that they’ll get through this time of virus, that’s, I think, where people need to focus.
Meb: And so, you know, short summary is you guys still find decent opportunity out there today.
Chris: Absolutely. And we tend to be looking at what’s going down the most where there’s high conviction that they’ll get through it. I don’t wanna look at companies that are gonna need…or where there’s a realistic chance that they may need to do a financing because we don’t know what the terms will be and they may be punitive and they may be capricious or they may be very reasonable. We don’t know. So I wouldn’t automatically just look at what’s gone down but if you start with that universe and then say, “Within that universe, what’s durable? What’s discounting a lot of bad news? Where are they doing the right things? Where is their earnings power largely intact when we get on the other side?” Then there are real opportunities there.
Meb: So for someone who’s been in the business for a while, whose family’s been in it, you don’t see too many continually operated funds with five-decade track records. As you look around the landscape…again, it’s a new decade, where…whether this could be policy on the investment business side. There’s a lot of legislative politicians that continually weigh in on the business world, and I’m purposefully leaving this a bit broad, this question. But also the investing landscape. You guys have been pretty innovative with launching ETFs as well as traditional mutual funds, separate accounts. Any general thoughts that have you curious, interested areas that you think are…you have some opinions that you think would be meaningful to how the conversation or discussion is going in the sort of public policies here? I’m giving you an open mic. Anything that’s on your brain while you’re listening to the chickens in the background? If there are any. I can’t hear any chickens but I just assume there’s some running around.
Chris: What I’d say is there’s a lot of fundamentalism out there on every side and that’s always dangerous. We like to say at our place where…we don’t wanna be optimists or pessimists. We wanna be realists. And when you get real fundamentalism where people don’t care what the facts are and that is as true at both sides of the political spectrum, you really get some powerful destructive forces. And I think the one that I worry about the most, long run, is just that the policy cycle to address some real long-term issues is much longer than the election cycle. And that makes it hard to fix. And the analogy I would leave you with is to think about General Motors. If you were the CEO of General Motors in 1980, you knew that there was a pension time bomb. But you also knew it wasn’t really gonna come due for a long time so you may as well keep offering the benefits, don’t take the big strikes. Just go along with the flow. And if you were the CEO in 1986, same thing. In 1996, same thing. Sooner or later there is gonna be a CEO on the bridge when finally the water came over the rails. And that CEO was gonna take a lot of blame for something that had nothing to do with him. And it was just the incentive systems in place made it hard for anyone to wanna deal with something really unpleasant where the benefits would be realized by their distant successors. And there’s a risk in government of that playing out at a big level where we, of course, are assuming an enormous amounts of government debt, which are really incumbering our children and our grandchildren. And that’s not the way you would wanna run your family. I mean, can you imagine saying, “I’m gonna borrow money on my credit card but the good thing is I don’t have to pay for it. My grandchildren will have to pay off my debts”?
And so I do worry about that and that’s sort of a nonpartisan worry. I worry about just having the discipline to say no when the election cycle is shorter than the policy cycle. Now, having said that, what I would say is whenever a client comes to me and they say, “Oh, I hate this administration or I hate the prospect of the opposite administration or…” I always say, “Well, if you think that…” We have basically…half our clients think one party is gonna destroy the country and half think the other party is gonna destroy the country. And when they think that, often their conclusion is, “I’m scared. I better go to cash.” And my argument then is, “You know, what you really wanna own…” If you think the world is going to rock and ruin, you wanna own businesses that are resilient and can adapt. Now if you were in Italy in 1960 and I said, “We’re gonna probably have…” I don’t know the number but I would guess 25 or 30 governments. We’re gonna have the lira depreciate by 70% or 80%. We’re gonna have enormous corruption and fiscal corruption. What do you wanna own? Well, if you own Ferrari, you did pretty damn well. You wanna own assets that have earnings power over time. And so what I’d say is whenever somebody paints an awful economic picture over 5 years or 10 years I always say, “Well, it’s probably a good idea then to own some businesses that can adapt.” Coca-Cola’s made a lot of money in a lot of countries that had a lot of problems for decades because the business has much more value than owning the bonds, owning shiny, yellow bricks of gold and maybe of owning Bitcoin. I don’t know enough about that to say for sure but I sure like owning businesses that produce cash every year and are resilient and have the ability to adapt.
Meb: We did an article on the blog called…first one was the “Get Rich Portfolio,” but the second was the “Stay Rich Portfolio” and it kinda walks you through…particularly on an after inflation basis that actually investing a fairly decent chunk of your safe cash, you end up with a similar, arguably superior risk profile. And we’re talking one-year drawdown, volatility, everything if you actually invest a decent chunk of it in risky type assets like equities rather than just in cash. But owning businesses is something that certainly resonates. Look, I have again mentioned that would love to do this for a few more hours but we can do this again after we come up with our investor curriculum. Chris, what’s been your most memorable investment? You’ve been doing this for a while. Good, bad, in between. Anything that is seared into your brain?
Chris: Well, of course you always remember the ones that went wrong but I would say I think my favourite investment, and it’s been my biggest mistake, has been the Amazon. I met Jeff in 1998. I consider him a friend and somebody I admire greatly. I’ve owned the stock three different times and each time I bought it it’s gone up a lot and I’ve thought, “Oh, my God. Too rich for my blood. I better get out.” But when we mentioned the reading curriculum and I mentioned Titan, you know, to look at what Jeff has created…I mean, unbelievable. I mean, in this time, the value of Amazon, what it’s done. You can’t imagine this quarantine without it. And that’s not just true of their retail and shopping business. It’s true of the ability they’ve had to flex and keep the web up and running through their cloud services. So I would say amazon has been my favourite investment because I admire the character and the leadership and what he’s created and it’s also been my biggest mistake because although it’s one of my largest positions, it’s still tiny compared to what it would be if I hadn’t been a bonehead and sold it all the way up. So every single person that listens to this should go and order the last 20 years of annual reports of Amazon and read them because when the John D. Rockefeller book is written for this generation, it’ll be about Jeff Bezos.
Meb: It’s a great illustration too that when you invest in stocks and private businesses, anything, the ability for these to really have major compounding, the power law, the 10, 100, a 1,000 X, baggers. It takes time. I think everyone who invests in stocks expects them to magically go up really fast but one of my favourite old investing books, “100 Baggers,” where it looks at the characteristics a lot of these stocks over the decades, and many of these take 10-plus years to get to that status. And the challenge, as you mentioned, how hard is it to hold on to those because most of us, if you bought an investment and it doubles, like we’re dancing the jig and so excited thinking about vacation and buying a vacation house and everything else, but that’s just for the really big winners one step on the path to 5, 10, 100 bagger status, which is, for most people truly life altering. Anyway, it’s a good example.
Chris: We cut the flowers and water the weeds.
Meb: That’s a fun one. We use it a lot as an example about investing through drawdowns too because the 50% and 90% drawdowns that’s experienced also would…shook out a lot of people, but I’m definitely interested in seeing your plaque of worst mistakes too one of these days because I’ve heard you talk about a lot of the tough investments as well.
Chris: That is a big wall and there’s a lot to learn from mistakes. And those mistakes don’t have to be something that you bought and lost money on. They can be things you bought and made money on, but you got lucky or they could be mistakes of omission. Sometimes the things you fail to do that you ought to have done. So I always commend people to spend a lot of time looking at their mistakes. It’s a much better way to get to improve.
Meb: Chris, this has been a blast. Where do people find you, what you’re up to, all your writings, investment updates? Where do they go?
Chris: Well, they go just to our website, it’s davisadvisors.com, and we try to keep a lot of communication and we don’t really have sales literature. Instead we try to provide information documents and particularly to the advisor community who are our partners, and I really appreciate you giving me this chance to speak with them and to speak with investors generally.
Meb: Awesome. It was a blast. Thanks so much for joining us today.
Chris: All right. Thank you so much. I really enjoyed it.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcasts. If you love the show, if you hate it, shoot us email@example.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. My current favourite is Breaker. Thanks for listening, friends, and good investing.